Risk and reward are inseparable twins – to earn reward you must take risk. This lesson shows you how to determine your risk tolerance as an investor, identify the risks faced by companies and the interplay in the relationship between risk and return and the metrics used to measure risk-return profiles such as beta and the risk-to-return ratio.
What is risk?
Risk in an investment context describes the situation where an investor exposes – by buying shares – their capital to the possibility of an erosion in its value or when the investment fails to meet performance expectations.
It also applies to the risks encountered by companies themselves and these will be major considerations for prospective investors in a company’s stock.
An investor must take greater risk to secure higher returns.
These are the risks faced by investors
As shareholders we hold stock positions with the expectation of earning a future higher return through an appreciation in the share price.
The level of uncertainty regarding the ability of an investment to generate an adequate return broadly determines the risk level you face as a shareholder.
Why volatility is central to risk
All of us as investors experience risk in the first instance directly through the profit and loss on our investments.
It is the ups and downs of share prices that determine capital returns (as opposed to income from dividend payments) – and it is this price volatility that often dominates our concerns as private investors.
Volatility risk is in play when an investment portfolio or stock valuation changes, resulting either in a loss or by failing to meet expectations. The higher volatility, the higher the risk that a share price sustains negative returns.
How volatility fuels gains, but also brings risk to capital
Understandably, the risk of suffering a capital loss means many investors are inclined to include an element of capital preservation into the methodology behind their portfolio building.
If you are more of a trader than an investor (short-term v long-term investment horizon), then volatility is your friend.
The greater the volatility of a stock the greater is the risk-reward opportunity it presents. If a stock price hasn’t budged out of a tight trading range for several years, it does not present an attractive risk-reward profile, unless you are an income-focused investor concerned more with consistent dividend payments than capital appreciation from a rising share price.
Volatility is at the heart of momentum investing, which has it that a rising share price is a reason to buy, assuming the trend can be identified as one that is set to continue.
What is your risk tolerance?
An investors risk tolerance is governed by a number of elements, including:
- Investment goals
- Time you have to invest
- Your wealth
- Fear factor
What are your goals?
What are you investment goals? Perhaps you are investing for a medium-term goal such as raising funds for a first house purchase. Maybe you are investing as part of a savings account for a child? If you are saving for a pension and intend to access it within a year or two, then that goal may steer you towards less risky investments that can be easily liquidated. A younger person may be investing because they want to target high returns from their favourite tech stocks and likely to trade in and out of stocks frequently to maximise returns from their risk taking.
Why experience matters
Not all investors are equal. Although the days when market information and data was only available to a select few are long gone, making sense of the mass of information now available to individual private investors is another matter.
Perfect competition theory assumes that all market participants have access to the same market knowledge, prices and data. Further, the efficient-market hypothesis has it that stock prices fully reflect all market information, which if true would mean it is not possible to “beat the market” (beat the average return of a market or benchmark index).
An investor may take issue with the assumptions behind these theories, that all market participants react in the same way to price movements and market news.
Looked at from a risk perspective, investor experience (or the lack thereof) is therefore a key reason for risk taking, unwittingly or otherwise.
What’s your investment horizon?
How long an investor is willing to wait for an investment to bear fruit is known as the investment horizon. The longer this horizon is, the riskier the investment can be and conversely, the shorter the horizon, the more cautious the investments should be.
The older you are, the more cautious you may need to be with your investment because you may require them to provide a steady income in retirement.
On the other hand, younger investors will be in a position to take on more risk because if the investment performs below expectations or suffers capital loss, there is ample time to repair the damage.
What are your financial resources?
The answer to that question may colour investor risk tolerance.
Those with deeper pockets may be able to diversify their sum of financial asset classes or stock portfolio.
For example, an investor with a 2% allocation to speculative stocks in an otherwise balanced portfolio valued at 100k is taking far less risky a position than that of an investor who puts £2,000 into speculative stocks.
What is the ‘fear factor’?
If you make an investment and then immediately start worrying about it, then it means you are breaking your own “natural” risk tolerance threshold.
To avoid finding yourself into such a situation, investors need to be objective about their subjectivity – be true to your own internal risk-o-meter.
These are the risks faced by companies
We have identified four main categories of risk:
1. Market risk
Value of equity and investments falls.
Three market risks faced by a company:
- equity risk
- interest rate risk
- currency risk
Equity risk: value of company equity falls; Interest rate risk: interest rate (yield) on a company’s debt rises, thereby reducing the value (price) of the bonds; Foreign exchange risk: unfavourable foreign exchange rates increase expenses.
2. Business risk
There are numerous business risks a company may have to struggle with. Business risk arises from factors such as competition, the impact of changing consumer tastes and preferences, government regulations and the risks associated with a deteriorating economic outlook.
3. Liquidity risk
Threat that unforeseen circumstances might arise requiring cash settlements and the company finds itself in the position where it is unable to liquidate sufficient assets to meet those new obligations.
4. Inflation risk
This is the risk that the cash returns from an investment are eaten into by inflation. Arguably this is not a top concern for most investors currently because of low and stable general price levels.
What is the relationship between risk and reward?
When you invest your money, you do so on the understanding that you will be compensated for the risk you take with your capital.
The more risk you take, the greater should be the reward, and the lower the risk the lower reward.
We can express this with the risk-reward matrix, as shown below:
What is Beta?
Beta is a volatility metric – it measures a stock’s share price fluctuations compared to the overall market or a benchmark index.
A stock is highly correlated with the wider market if it has a beta above 1.0. If a stock has a sub 1.0 beta, it is less correlated than the market.
What is Alpha?
A stock’s alpha measures its return on investment compared to the overall market or a benchmark index.
What is the risk/return ratio?
Before we invest our money it is imperative that we have an idea of how much risk will need to taken to achieve targeted returns. This is where the risk/return ratio comes in.
Risk/reward ratio formula:
risk/return ratio = net profit / price of maximum risk
Follow this example of how to use the risk/return ratio and stop-losses
Let’s start by buying 10 Genedrive shares at 115p with a target price of 200p
Gain 850 (85 x 10 shares)
net income = 850
Price of max risk = 1150
850 / 1150 = 0.73
The risk/return ratio is 0.73:1 (0.73 to 1)
That is a very low ratio. A minimum is considered to be 2:1, with 4:1 a good risk/return ratio.
However, we can raise our price target to improve the ratio: buy 10 shares at 115p (1150)
Gain 1850 (185 x 10 shares)
Net income 1850
Price of max risk 1150
1850 / 1150 = 1.6
The new risk ratio is 1.6:1
That’s a much better reading, but it is likely that your capital will be tied up for longer to earn the higher reward, and it is still below 2:1.
How to use stop-losses to reduce risk
There’s a way we can reduce the risk by adding a stop loss to our position. A stop-loss automatically closes a position at a predetermined level below the buying price.
If we set a stop-loss at 100p, we are only risking 15 (buying price 115 – stop-loss level 100 = 15) as opposed to 115.
Net income 150 (15 x 10 shares)
Price of max risk = 15
150 / 15 = 10
Risk/return ratio = 10
Is the risk/return ratio a useful tool?
The risk/return ratio is an easy-to-use ratio and provides you with a way of setting a target that is in line with your risk tolerance and risk profile.
When using the ratio we are afforded great lee-way, which can lead to setting unrealistic price targets in order to reach a threshold.
Instead we should already have in mind a threshold that reflects our risk appetite and deploy the ratio to find those stocks that fit the risk profile.
Also, the risk/return ratio has nothing to say about the sources of risk